Bond risks in ‘overpriced’ US stocks

The most “overpriced” US equity markets for years have increased the risks for corporate bond markets, according to the chief economist at Moody’s Capital Markets Research.

Writing in Moody’s credit markets bulletin, John Lonski said US stock markets could yet reach new highs despite the slow growth of corporate profits.

Whether US markets set new records depends on key US interest rates staying at “extraordinarily low” levels, and as long as corporate bond yield spreads “do not swell”.

Mr Lonski said bond markets are expecting the default rate on high-yield bonds (the riskiest lending) to eventually fall back to 5% by this time next year.

“Equity market performance matters greatly to corporate bonds, especially those rated less than high grade,” he said.

“The strong performance by US equities since early 2016 has facilitated a notable stabilisation of many high-yield credits and has helped to trigger credit rating upgrades.

“If, however, the default outlook worsens, corporate bond yield spreads will widen and share prices will slump noticeably.”

US and other world stock market indices have climbed this year despite the challenges facing the world economy.

The S&P 500 index has risen 7.25%, while the narrower Dow Jones index has gained 6.5%.

The Ftse 100, which includes many international companies, has also risen strongly, by 10%, despite the shock of the Brexit vote in late June.

“The high-yield credit ratings of seven issuers from the hard-hit oil and gas industry have been upgraded thus far in the third quarter because of infusions of common equity capital, mergers, or asset divestments,” writes Mr Lonski.

“These financially driven upgrades received considerable support from a firmer equity market regardless of whether market valuations are fundamentally sound.

“Nevertheless, the most overpriced equity market since 2002 preserves the possibility of a disruptive correction by share prices that could swell high-yield spreads and diminish high-yield liquidity.”

Yesterday, US stocks slipped for the first time in three days, with a recent rally showing signs of tiring amid elevated valuations and speculation over the potential timing of higher borrowing costs.

Investors were selling this year’s winners, with US phone companies headed towards their worst week since 2014, while utilities and energy producers also led declines.


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